UNITED STATES SENATE
Committee on Energy and Natural Resources
Committee Chairman: Jeff Bingaman
Washington, DC • April 3, 2008
The Price of Oil: A Reflection of the World
By James Burkhard, Managing Director, Cambridge Energy Research Associates
It is an honor to address this Committee on the relationship between oil prices and the
influence of noncommercial institutional investors, sometimes referred to as market speculators.
Trading in futures markets establishes the reference price for nearly all crude oil sold in the world.
Crude oil futures trading activity on the New York Mercantile Exchange—the largest in the
1world—is currently about 350 percent higher than in 2002. Noncommercial investors have
contributed to this increase. Growth in trading activity is coincident with a rise in oil prices from
$26 per barrel in 2002 to more than $100 in early 2008. The concurrence of these two trends has
raised the question about the level of influence that noncommercial investors have in oil price
What has been driving oil prices upward? It is primarily the fundamentals of demand and
supply, geopolitical risks and rising industry costs. The decline in the value of the dollar has also
played a role, particularly in the past six months. But with noncommercial investors playing a
bigger role, the direction of a given price trend can be accentuated. And since the credit crisis first
erupted last summer, energy and other commodities have become caught up in the turbulence of
the global economy.
1The figure of 350 percent represents the increase in open interest in NYMEX crude oil contracts, which is a proxy for levels of trading activity. Open interest is defined by the US Commodity Futures Trading Commission as “the total number of futures contracts long or short in a delivery month or market that has been entered into and not yet liquidated by an offsetting transaction or fulfilled by delivery.”
The US Commodity Futures Trading Commission defines noncommercial or speculative
investors as those who are not physically exposed to the commodity but trade “with the objective
of achieving profits through the successful anticipation of price movements.” This group of
market participants includes more than just short-term speculative traders. It represents a broad
spectrum of investors with different time frames and motivations such as mangers of pension
funds, university endowments and other institutional investors. These investors increasingly view
commodities and oil in particular as an asset class. They allocate investment capital based upon a
view of the world’s need for oil and other commodities. For example, the California Public Employees Retirement System (CalPERS), the largest public pension fund in the United States,
recently increased the amount it could invest in an asset class that includes commodities. This
move is part of a “new strategy to provide a hedge against inflation while diversifying investments,
2thus mitigating losses during equity market downturns.”
Noncommercial investors are an essential part of a futures market. In the 1860s Chicago grain
traders developed the first futures contract: an agreement to buy or sell a commodity at a future
date. Farmers were able to offload price risk to speculative traders. In exchange for providing
price certainty to the farmer, the trader had the opportunity to turn a profit—or a loss—from
future price changes. This allocation of risk remains the foundation of today’s futures markets.
Noncommercial investors can also provide another attribute of a well functioning futures
market: liquidity. Liquidity refers to how quickly a counterparty can be found for a transaction.
The current turbulence in credit markets illustrates the dangers that materialize when trading in a
market becomes illiquid. Uncertainty and fear come to the fore, which exacerbates market turmoil.
Oil futures markets are among the most liquid in the world—and have remained so despite the upheaval in credit markets.
In a sufficiently liquid market, the number and value of trades is too large for speculators to
unilaterally create and sustain a price trend, either up or down. The growing role of non-
2 CalPERS February 19, 2008 press release.
commercial investors can accentuate a given price trend, but the primary reasons for rising oil
prices in recent years are rooted in the fundamentals of demand and supply, geopolitical risks, and
rising industry costs. The decline in the value of the dollar has also played a role, particularly since
the credit crisis first erupted last summer, when energy and other commodities became caught up
in the upheaval in the global economy. To be sure, the balance between oil demand and supply is
integral to oil price formation and will remain so. But “new fundamentals”—new cost structures
and global financial dynamics—are behind the momentum that pushed oil prices to record highs
around $110 a barrel, ahead of the previous inflation-adjusted high of $103.59 set in April 1980.
New Cost Structures
In 2004 the price of oil (in nominal terms) averaged above $40 for the first time ever. This
was sparked by extraordinary demand growth that reflected strong global economic expansion
and a temporary surge in the use of oil to generate power in China. Further demand growth in
2005 reduced spare oil production capacity to just 1 million barrels per day (mbd)—compared
with 4 to 6 mbd in the 1990s. Amid the whittling away of spare capacity, political change and
security worries in several major oil exporting countries fueled anxiety about the adequacy of oil
supplies. With so little spare capacity, such fears drove oil prices higher.
As oil prices rose, so did demand for the people and equipment needed to find, develop and
produce oil. But nearly 20 years of low oil prices and industry consolidation meant “a missing
generation”—a generation that skipped entering the petroleum industry. As a result, major
shortages of equipment and personnel dramatically raised the cost of developing an oil field
whether in the Gulf of Mexico, West Africa or the Middle East. CERA and IHS have developed a
series of indices to measure changes in cost—sort of a Consumer Price Index for the energy
industry. Costs to build power plants and oil refineries have surged higher. But the one most
relevant to our discussion today is the latest IHS/CERA Upstream Capital Cost Index. This index
shows a doubling of oil field costs over the last three years. In other words, companies have to
budget twice as much today as they did three years ago. Adding to the cost pressure are
increasingly heavy fiscal terms on oil investments in the form of higher taxes and greater state
participation in oil projects. The net result is that much higher oil prices are needed to support
development of new supplies. Some projects that in the past needed oil prices of $20 or $30 in
order to move forward now need price levels that are double that amount—or even higher.
It can take ten years or more to find, develop and begin production from a new oil field,
particularly if it is large and complex. Long lead times and the severe upturn in costs have led to
one of the most significant changes in the oil market: a steep increase in long term oil price
expectations. For nearly two decades, until 2004, expectations for long-term oil prices hovered
around $18 to $25 per barrel. Since 2004 the price of a futures contract to buy or sell crude oil
five years out has risen steadily. It topped $100 per barrel this year. Five years is considered long-
term from an oil market perspective as opposed to the longer times that can be required to
develop a new oil field. The sustained breakout of oil prices from a relatively narrow historical
range along with global financial dynamics has fostered greater interest in oil among financial
Global Financial Dynamics
The oil price has long reflected major trends in the economy and geopolitics. Rising inflation,
a rush to invest in commodities and worrisome tension between the United States and Iran drove
oil above $100 per barrel in real terms in 1980. In 1998 the price of oil collapsed largely because
of the fallout from the Asian financial crisis. Today, two major trends that are reflected in the
price of oil are the decline of the dollar and the rising economic clout of many regions outside the
Oil and the Dollar: The New Gold
The effect of a declining dollar on the price of oil first became prominent in early 2005. The
dollar had fallen about 35 percent relative to the euro since 2002. OPEC generally imports more
from Europe than the United States, so a weak dollar damages terms of trade from OPEC’s
perspective. The falling dollar contributed to the lifting of OPEC’s implicit oil price objective,
which altered market expectations about price and the balance between demand and supply. The
price of oil was nearing $50 per barrel—a very high price at the time.
In the past half year lower interest rates and anticipation of further cuts in interest rates
pushed the dollar lower. Amid great turbulence in credit and other financial markets, the nature of
the weak dollar’s influence on the oil market changed. Oil has become the “new gold”—a
financial asset in which investors seek refuge as inflation rises and the dollar weakens. This may
seem counterintuitive at a time of weak oil demand in the United States, but today’s dynamics in
the marketplace reveal oil’s increasingly cosmopolitan nature. The price of oil reflects not only
demand and supply, but broader macroeconomic and geopolitical changes such as the growing
influence of Asia, the Middle East, Russia and the Caspian countries.
Strong economic growth outside the United States has not only supported growing oil
demand but also propelled rising demand and prices for many commodities. In addition to energy,
food prices are surging around the world. According to the International Monetary Fund. global
prices for cereals—wheat, rice, corn (maize), and barley—increased 82 percent from 2000 to 2007. More than half of this increase has been in the past two years. Recent data from China show
food prices pushing overall inflation to 8.7 percent—the highest level in more than a decade.
A key element of the “oil as the new gold” story is the expectation that demand for oil will continue to grow, and thus be able to hold its value despite a weak dollar and rising inflation. To a
degree, an expectation of a strong oil price is a bet on the future of China and India. The United
States is the world’s largest oil consumer, but 75 percent of global demand is outside the United
States. For example, since the beginning of 2007 eight of the ten largest oil markets in the world
(excluding the United States and Saudi Arabia, whose currency is pegged to the dollar) have seen
significant currency appreciation ranging from 9 percent (India) to 19 percent (Brazil). When a
currency appreciates against the dollar, it diminishes the impact of an increase in the dollar price
of oil in that market. Also, regulated prices of gasoline and diesel in some key markets means that
consumers are not exposed to the full increase in the global market price of those products. This
places pressure on government and company budgets, but if a given country enjoys strong
economic growth it can withstand, at least for a time, rising oil prices.
If economic and oil demand growth remain vibrant in large markets around the world and the
dollar continues to weaken, then financial dynamics could continue to drive oil prices higher. But
oil’s role as a financial hedge does not mean that its price will rise continuously. Prior to the
ascent in recent years, both gold and oil prices had been mired in long-term price slump. In the
late 1990s, $100 oil—or even $80 oil— seemed preposterous. Today, $20 oil seems quaint.
The political and manpower difficulties currently constraining oil supply growth will not
disappear overnight. The desire for higher living standards in China, India, the Middle East,
Russia and elsewhere will remain as strong as it was in Europe, Japan and the United States in the
post World War II years. Higher living standards mean longer life expectancy, lower infant
mortality—and higher energy consumption.
But just when the future seems preordained in the oil market, the unexpected can unfold. It
did in the decade following 1998, just as it had several times since 1970. This year will be a stiff
test for the new oil price era that dawned on the world several years ago. Economic growth is the
single most important determinant of oil demand growth—and the course of the global economy
in 2008 is fraught with worries.
Financial innovation and the globalization of securities helped to lubricate the wheels of the
global economy during an extraordinary expansion, but it also created risks that were not—and
still are not—fully understood. The US subprime mortgage meltdown is the most current example
of misunderstood risk, but is it the last?
Oil prices can remain high during an economic downturn. In the early 1980s, one of the
weakest periods of economic growth since the depression of the 1930s, oil prices were at very
high levels for several years. But eventually, the economy and demand catch up: the 1986 oil price
collapse was due to a multiyear decline in oil demand.
This year, just as economic worries began to mount, oil prices touched a new high of about
$110 per barrel. Although oil prices are only one factor affecting the global economy, they are a
significant one. Because the world economy took $70 per barrel in stride does not mean that it
would easily absorb $100. If prices hover in the $90-$100 plus range for six months or more, then
it would be increasingly difficult to argue that high oil prices do not have a significant impact on
economic growth. Moreover, given the growing use of corn-based ethanol, oil prices are now
connected to food prices, which are rising. And the increase in food prices is a major source of
inflation in many emerging markets around the world. Oil prices are fluctuating in line with the
latest economic signals—up and down. This will continue until a clearer view of economic growth materializes. But one factor is clear. The price of oil will reflect major swings in the value of the
dollar—both up and down.
James Burkhard, Managing Director of CERA’s Global Oil Group, leads the team of CERA
experts that analyze and assess oil markets and strategies. His team also develops and maintains
detailed short- and long-term outlooks for global oil supply and demand. Mr. Burkhard's
expertise covers geopolitics, world economic conditions, and global oil demand and supply
trends. Mr. Burkhard was the project director of Dawn of a New Age: Global Energy Scenarios
for Strategic Decision Making—The Energy Future to 2030, CERA’s comprehensive study
encompassing the oil, gas, electricity and renewable energy sectors. He is also the coauthor of
CERA’s respected World Oil Watch, which analyzes short- to medium-term developments in the
oil market. In addition to leading CERA’s oil research, Mr. Burkhard served on the US National
Petroleum Council (NPC) committee that provided recommendations on US oil and gas policy to
the US Secretary of Energy. He led the team that conducted the energy demand analysis and
developed the demand-oriented recommendations that were published in the 2007 NPC report
Facing the Hard Truths About Energy. Mr. Burkhard holds a BA from Hamline University and
an MS from the School of Foreign Service at Georgetown University.